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Thoughts on Retirement

Start planning now, and the power of compound interest will be on your side.

As you may know by now, we've begun enrollment for the Fool's next online seminar, Roadmap to Retirement. Although I've got a number of years to go before I retire, it's certainly a subject that's near and dear to my heart whenever I think about my investment goals. Let's review one of the best ways to save for retirement in today's column -- which has been updated after originally running on December 21, 1999.

The most lucrative retirement accounts are those that are available through your employer. Most often, this is in the form of a 401(k). (And in case you're wondering, the name comes from the section of the Internal Revenue Code that contains the applicable rules. Also worth noting is that educators use 403(b) accounts instead.) There are a number of advantages to these accounts.

One of the best parts is that it's a snap to invest in a 401(k) as contributions are made through automatic payroll deductions. (After a while, you won't even miss the money!) Another advantage is that the contributions are made with pre-tax dollars. Not only that, but money invested in a 401(k) is able to grow on a tax-deferred basis. In addition, many employers will match at least a portion of your contributions.

The employer match is a very important employee benefit. Companies that I've worked at have matched some percentage of up to 6% of my gross income. The match has ranged from 50% to 100% of my eligible contributions. Sometimes I find that the best way to really understand the advantages of opportunities like this is to work through some numbers. I'll do the calculations, so all you need to do is sit back and follow along.

To make everything work and easier to follow, I'll ignore deductions and exemptions from income. I also won't consider state taxes as the rules can vary from state to state.

As a baseline for comparison, here's our hypothetical $50,000 income individual -- we'll call her Nelly No-Save -- with a 28% tax rate:

Nelly:

Salary: $50,000

Income Tax @ 28%: $14,000

After-tax income = $36,000

Now let's say that Solomon Super-saver, who also makes $50,000, adds a 401(k) contribution:

Solomon:

Salary: $50,000

6% 401(k) Contribution: ($3,000)

Taxable income: $47,000

Income Tax @ 28%: $13,160

Tax Savings = $840 (that is, $14,000 minus $13,160)

After-tax, after-401(k) income = $33,840

Okay, so let's compare. Without saving for retirement, Nelly takes home $36,000. Her friend Solomon, however, was able to save $3,000 towards her retirement and still take home $33,840 -- only $2,160 less than Nelly. Essentially, Solomon achieved an immediate 38.9% return on his money! (The math works like this: ($3,000 / $2,160) -1 = 0.389 or 38.9%)

For fun, let's take this example one step farther. Suppose that Solomon also enjoys the benefit of a 50% employer match. That would result in an additional $1,500 of savings. Add up the pieces, and you'll see that even if the 401(k) investments are flat, Solomon will get quite a nice return on his 401(k) contribution. For Solomon's $3,000 contribution, he gets a matching $1,500 from her company, so that means $4,500 in his 401(k) versus an alternative of $2,160 in after-tax income. Hmmm, which sounds better? The 401(k) with 50% matching gives Solomon 108.3% more money than the after-tax alternative.

This is an example of why I believe 401(k) plans are one of the best benefits that companies offer. When I started working, I failed to participate in my company's 401(k) for the first couple of years because I had some school debts to pay off. I also mistakenly thought there was no reason for me to worry about my retirement as that event was so many years away. May I suggest that if you're currently eligible for a 401(k) plan and aren't contributing, then you should strongly consider making such contributions a top financial priority.

The one disadvantage of many 401(k) accounts is that your investment opportunities are often limited to various mutual funds. Some companies supplement some of the expenses, which helps, but in many cases that doesn't make up for the poor performance that many of the funds generate. However, the tax advantages that I mentioned in the above example helps to overcome that. Personally, I've also made it a practice to transfer my 401(k) to a self-directed IRA whenever I change jobs. (You can learn how to do this in our Discount Brokerage Center.) If you do this as a fund-to-fund transfer, there are no current tax consequences. This allows me to invest in individual stocks of my choosing.